The Employee Retention Credit (ERC) – sometimes called the Employee Retention Tax Credit or ERTC – is a refundable tax credit for certain eligible businesses and tax-exempt organizations that had employees and were affected during the COVID-19 pandemic. Whenever the government rolls out a massive program designed to get funds into the hands of those who need it as quickly as possible, fraud will follow. Because of the high level of cases the IRS has determined are problematic, many taxpayers will find themselves having to affirmatively litigate to obtain the credit. For those taxpayers who have filed claims that have not been processed, claims that have been out-right denied, or claims that have been partially denied, litigation may be the only option.
Problematic Nature of Many ERC Claims
On June 20, 2024, the IRS announced plans to deny tens of thousands of ERC claims it determined were both improper and high-risk. According to the IRS, it engaged in a months-long review of more than 1 million ERC claims that amounted to more than $86 billion in claimed credits. Individual taxpayers who were not employers were not eligible for ERC. In order to be eligible, a business must have either:
Failure to meet these requirements will result in denial of an ERC claim, either in whole or in part.
Administrative Refund Claims – The Good, The Bad, and the Ugly
An ERC claim is simply a claim for refund. Like all claims for refund, they are subject to refund procedures. Refund procedures require taxpayers to submit a claim for refund either on an amended federal tax return or on IRS Form 843, Claim for Refund and Request for Abatement. Eligible employers who are claiming an ERC and did not do so when they filed their original return can file an ERC claim by amending their IRS Form 941, and file IRS Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund.
Rare is the refund claim that is granted upon initial request – regardless of the nature of the claim. In my 15+ years as a tax litigator, I’ve seen it happen less than ten times. One of the most stinging criticisms we have seen of the way the IRS has handled ERC claims is that often the denial letters make no sense in light of the claim, are missing key information, or fail to inform taxpayers that they have a right to appeal at the IRS Independent Office of Appeals. I wish I could say this is new behavior from the IRS, but it isn’t. I took over handling of a refund case and here’s a snapshot of what the IRS said when the refund claim was denied:
In other words, the claim was denied because the claim was denied! How enlightening. That case was about an estate tax refund, it wasn’t about penalties. The description of why the refund claim wasn’t allowed, because the IRS declined to abate penalties, had nothing to do with what the taxpayer was asking about.
Now consider how the IRS will be able to accurately process claims for the massive influx of claims through ERC, in addition to processing every-day, typical refund claims. The system was already flawed, and it is now even more overloaded.
Essential Businesses Bear the Brunt of Denials
Without question, some of the businesses seeking the ERC do not qualify and in fact, some were not even real businesses at all. Those denials should not be litigated. But experts such as Plante Moran’s Jennifer Keegan are seeing ERC claims that should be accepted either denied outright or given very low hazards of litigation at the IRS Independent Office of Appeals. Many of those cases center around so-called essential businesses.
Businesses deemed “essential” were able to stay open and operate, even during the height of the pandemic. But just because they were able to stay open doesn’t mean they weren’t impacted by the pandemic. Take hospitals, for example. Many hospitals had to cancel or reschedule all non-emergency surgeries. They were impacted by the pandemic, even if they were permitted to remain open. According to Keegan, “We have seen IRS examiners apply increasingly restrictive interpretations of ERC rules over the past year, particularly for taxpayers seeking to qualify based on partial suspension of their business. Even taxpayers who were heavily burdened by government orders are seeing their claims denied during exams and are receiving low settlement offers at Appeals.”
Daniel Mayo, a tax partner with Withum, has also experienced mixed results. He explained, “We are succeeding in most of the cases we are bringing to Appeals, but the IRS is holding the line and refusing to settle when it comes to essential businesses.”
“Appeals is likely to get very overloaded soon not only with cases coming from exam but also cases challenging the outright denials being issued without an examination, which we’re starting to see,” said Marissa Lenius, Senior Manager, RSM US LLP, Tax Controversy Practice. “Some taxpayers have received denials alleging there were no government orders and no decline in quarterly gross receipts based on IRS records when in fact taxpayers did have the requisite quarterly decline in gross receipts. There is no way for the IRS to draw that conclusion without an examination.”
The essential businesses that were able to remain open – albeit partially or in some modified form – but were impacted by the pandemic are likely going to be at the heart of the next wave of ERC defense, which will be litigation.
Litigation is Next
Businesses that have a legitimate claim but are not getting the results they expected to see in either exam or at IRS appeals will have to litigate if they plan to continue to pursue their claims. “Clients are eager to litigate to force the IRS to address their valid ERC claims, but they are frustrated that they need to incur additional expense to get the IRS to do what should have been done already,” said Mayo. Alina Solodchikova, a principal with RSM, agrees, adding, “Due to the lack of case law, and only procedural guidance from the IRS in the ERC space, we believe that many of the high dollar ERC refund claims may end up in litigation, if not resolved at the administrative level with the IRS Appeals.”
Like all administrative refund claims, once an ERC claim has been filed for six months or more, a taxpayer has a right to file a lawsuit in federal district court or the United States Court of Federal Claims to enforce the refund claim. And also like all administrative refund claims, most taxpayers who are claiming the ERC will want to hold off on litigating until absolutely necessary. Why? Litigation is expensive.
First, the employers will have to determine where to file the lawsuit. A taxpayer must file a suit for refund of taxes paid in the United States district court where the taxpayer resides (or where a corporation has its principal place of business), or in the Court of Federal Claims. The main difference between the United States district court and the Court of Federal Claims is that in district court, either party can request a trial by jury. In the Court of Federal Claims, all cases are decided by a judge and there are no juries. Both are litigated by attorneys who work for the Department of Justice, Tax Division, in the civil division. (Cases that are litigated in United States Tax Court are litigated by IRS Office of Chief Counsel attorneys, not DOJ attorneys).
Second, the employers will have to determine what kind of resources to devote to the lawsuit. In the old days, I would tell my clients who were considering litigation in cases where we felt the IRS was dead-wrong that once we filed in court and a DOJ attorney was assigned and looked at everything, we could hope to quickly negotiate a settlement. In my recent experience, those days are over. In the past few years I have seen a significant shift, and now DOJ is unwilling to engage in productive settlement discussions until after significant discovery has taken place. That is expensive: the parties have to engage in document exchanges, answer written questions in the form of interrogatories, and both take and defend depositions.
My own view is that this is really bad tax policy. As an advocate for my clients and as a taxpayer myself, I hate when I can’t get the government to budge from what seems to me to be an obviously wrong point of view without wasting a lot of money – both my clients’ money in fees and Taxpayers’ money paying for what I deem to be needless review of something I view as obvious. However, I can also see from the government’s point of view: the IRS has already done extensive work to evaluate a claim, and denied that claim, so the DOJ attorneys need to assume that the IRS has done its job well and look at the taxpayer position through a very critical lens. The problem with that approach is that often we are not seeing refund claims get the attention they deserve. As a result, taxpayers who don’t get careful evaluation of their refund claim by the IRS on the front end wind up paying a lot more for the careful evaluation of their claims by the DOJ on the back end. Getting attorneys’ fees from the government is very difficult – harder than it should be in my opinion – but that’s a story for another day.
Third, as the ERC cases make their way through discovery, strategic decisions will have to be made regarding what, if any, issues to ask the judge to decide as a matter of law without a trial. Through a procedure called summary judgment, litigants can ask the court to rule on certain parts of the case without a trial. This is a way to narrow the issues that do have to be tried and to try to reduce both the cost of the trial and the time it takes to reach a resolution. Some of the issues that might be ripe for summary judgment will likely involve whether the IRS’s notices and application of the CARES Act complied with the law as passed by Congress. With the amount of money at stake, there will sure to be litigation to come.
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